The script is ripped

The Office for Budget Responsibility’s (OBR’s) March forecasts gave some welcome news to the Chancellor in the short term. The watchdog now predicts that inflation will drop faster than previously expected, with CPI expected to end the year just shy of 3%, while also forecasting that the UK will avoid a recession in 2023. This improved outlook gave Chancellor Hunt room to implement a series of tax and spending measures at the Budget which loosened fiscal policy by nearly 1% of GDP by 2024-25. 

However, while the Budget would normally dominate the news bulletins, it was overshadowed by financial market turbulence arising from troubles faced by a number of regional US banks and Credit Suisse. This turbulence not only precipitated a major correction in equity markets, but also led to future interest rate expectations falling as concerns around financial stability rose up the agenda. Then, the day before the decision on UK interest rates, the inflation print threw another curveball into the mix. It showed, against expectations, both headline and core UK CPI rising, leading to concerns over whether inflation is sufficiently under control. This, of course, led to a difficult backdrop for the Monetary Policy Committee (MPC) who had to weigh up carefully both price and financial stability considerations. 

The MPC decided to increase rates by 25bp up to 4.25% on a vote of seven to two, with the dissenters backing no change. Continuing tightness in the labour market and inflation surprising markets on the upside will have weighed on the minds of rate setters when making this decision. It is also notable that the MPC was briefed by the Bank of England’s (BoE’s) Financial Policy Committee that the UK banking system remains resilient: indeed, the UK banking system is now far better capitalised compared to the Global Financial Crisis and is subjected to stringent stress tests on a regular basis. This briefing will no doubt have offered reassurance to MPC members who may have otherwise been wavering in their decision. 

Returning to the surprise on CPI, February’s unexpected jump in inflation is probably simply a blip. Various factors continue to weigh down on future expectations of inflation: spot and futures energy prices have dropped dramatically; world food prices have come off the boil since last year; shipping rates tumbled last year; and supply chain disruption has seen significant fall. These factors should help by year end to all but eliminate the three quarters of CPI inflation that is currently accounted for by energy, food and goods prices. Significant progress in reducing inflation should be seen in April’s figures when base effects start showing up strongly (that is, last year’s irregularly high figure due to the Ukraine invasion is the comparison point for this year’s numbers so the drop will look more remarkable) .  

Services inflation, currently making up just over a quarter of CPI inflation, will be much stickier due to the influence that wage costs have in setting prices for that sector. The UK’s labour market remains tight, which will continue to put pressure on nominal wages, but the BoE’s latest analysis suggests wage growth will fall back faster than it was predicting in its February report.

We often joke when doing talks and presentations around the country that what we show our audience today will be wrong tomorrow, which unfortunately is part and parcel of a forward-looking market. But everything is relative, the numbers may change but normally the narrative remains on the same path, but we are now in a scenario where we have to rethink it all, and the story has completely changed. Perhaps now more than ever we have sympathy for the economists who have the impossible job of forecasting!

In last month’s wrap we spoke about the possibility of the hiking cycle coming to an end in the UK and US imminently, which was what the market was positioned for coming into 2023. However upside data surprises across both sides of the Atlantic sent markets into a frenzy with rate expectations accelerating, and in many cases was being backed up by central bank officials – particularly in the US. At its peak, markets were expecting the US Fed Funds rate to reach between 5.5% and 5.75%, whilst in the UK markets were hedging the possibility that Bank Rate gets lifted to 5%. Expectations for the European Central Bank (ECB) deposit rate was also firm, seen peaking at 4% - its highest level ever.

The collapse of Silicon Valley Bank (SVB) and Signature Bank in the US has caused a huge recalibration in expectations, as concerns rise over potential further contagion in the US banking system and beyond. On the whole this is completely understandable, despite central banks having inflation mandates and/or employment goals, effectively their sole reason for existence is to ensure stability in the banking system. This means they will do whatever it takes to avoid further fallout by providing the necessary support the system needs. We have seen this already with the Federal Reserve which launched the Bank Term Funding Programme in response, which will provide cheaper liquidity to banks for 1 year as a backstop should we see any runs on deposits. 

As some signs of calmness were apparent following the Fed’s actioned, further concerns around Credit Suisse (CS) hit the wires on reports its biggest shareholder Saudi National Bank will not provide further capital injections due to regulatory constraints. Problems at the Swiss lender are not new and the bank was going through a second major restructuring to phase out its investment arm to improve confidence and ultimately help its bottom line. Reports suggest that so far this had failed to stop client outflows ($100bn of assets in Q4 last year), which was likely exacerbated by the wider concern sparked by SVB. Despite defiant messages from the CEO around its liquidity position, both the share price and bond prices have plummeted. 

With signs of stress in the system, it’s a tough environment for central banks to continue tightening monetary policy further, which may have more damaging consequences later down the line. This view was shared within the market, and as a result short-term interest rates fell off a cliff, whilst longer-dated swaps and sovereign bonds also fell – the latter likely due to a flight to safety. Prior to the March Fed meeting, markets were weighing towards no hike at all, whereas during the days prior to the SVB news markets were hedging the possibility of a 50bp move. There had also been some bold calls, such as Nomura suggesting the Fed will cut in March and end quantitative tightening. The 2-year Treasury yield fell dramatically from a peak of 5.05% to as low as 3.63% in the space of just over a week, and has been whipsawing at extreme levels almost daily. As one could guess the moves in the US curve filtered over to Europe and the UK, where short-term implied rates for 2023 have dropped dramatically to show only one further 25bp hike in Europe and the UK.

This then brings the question of whether markets have overreacted. Most experts would say it’s extremely unlikely that we will see a string of bank failures that severely threatens the financial system – given how well capitalised the major banks are compared to the 2008 crisis. Yes there is concern on deposit runs for regional banks, but ultimately the threat right now seems rather small following the quick work from the Fed and Treasury, and talk of further expansion of the FDIC deposit insurance to cover all deposits above $250k should prevent further runs, assuming it can jump the legal and political hurdles which for now look complicated. Looking at SVB in isolation as well, its collapse was not due to a liquidity problem, but rather simply a very bad set of decisions that caused huge losses on its bond portfolio which then had to be crystalised. The Credit Suisse story is much more important, being a GSIB (Globally Systemic Important Bank). Eventually, we did see the Swiss central bank and regulators step in which ended up with CS being acquired by its rival UBS in a historic deal – one which for now ends the concern and debate around “who’s next?”.

We have seen banking stocks rebound, as well as some claw-back in rates, perhaps taking into account the fact that inflation reports in February proved sticky, and indicators of stress have eased, despite concerns about Bank AT1 bonds (bonds that convert into equity if a bank’s capital position falls below a trigger level) after these types of bonds issued by CS were essentially wiped of any value by the regulators in the acquisition. Rightly for now inflation is less of a priority, although I think before too long it will be front and centre of the markets’ minds again and therefore there is still a decent chance of a further unwind of the significant shift in rates. As ECB President Christine Lagarde mentioned in the press conference following the ECB meeting in March (see below), the bank is aiming to keep monetary (inflation focused) and financial stability tools separate, which means the inflation problem will not be swept under the carpet and is still on top of the agenda – of course there is a point where stability takes precedence, but at least in the central bank’s eyes we are not there yet.

Difficult meetings

First up was the European Central Bank, the day after the CS news. The central bank was left with a rather unenviable decision to press on with raising rates as initially communicated, or opt for a smaller or no hike at all to assess the extent of risks in the system. There are cons to both; on the one side if you hike by more than market is expecting (c 40bps coming into the meeting) you then risk creating unwanted tightening in financial conditions. However, if you pivot, you perhaps only confirm to investors that there are genuine concerns over the health of the sector which may spur further unnecessary panic. 

In the end, the ECB opted to stick with the planned 50bp hike taking the deposit rate to 3.00%, thus not ignoring the inflation problem. It was mentioned in the statement that the Governing Council is “monitoring current tensions closely and stands ready to respond as necessary to preserve price stability and financial stability in the euro area”. It also noted that the euro area banking sector is “resilient, with strong capital and liquidity positions”. The above pragmatism, which was echoed by Christine Lagarde in the press conference, seemed to go down well with limited reaction all round, and the expression of confidence in the system would have helped ease nerves too. We may see more dovish tones from the ECB in the coming weeks as it continues to monitor the situation, and has not pre-committed to any further hikes in the coming meetings.

This all set the tone for the Fed to not alter course, which ultimately proved to be the case with a hike of 25bp as expected, whilst echoing a similar tone to the ECB with a statement of confidence in the banking systems. There was a dovish reaction as the rate forecasts, shown by the dot plots, remained unchanged for 2023 with the median forecast at 5.1%, and only a slight upward adjustment in 2024. The Fed sees 75bps of rate cuts next year, slightly less than previously, and has kept the door open to further hikes. To me the strong move lower in rates (although moves of 20+ basis points a day have become the norm) was a bit of a reaction, as the importance of the forecast is materially reduced given we are still in the early days of this new environment. Although some were likely spooked by Treasury Secretary Janet Yellen playing down the expansion of the FDIC insurance protection to all deposits. The peak in Fed Funds was now expected under 5%, and rates cuts are discounted from the summer onwards.

Arguably the Bank of England had a slightly less difficult job, given there were no isolated stresses evident in the UK banking sector and it also had the benefit of the ECB (and also the Fed, but the decision would have been made before the MPC meeting). It proved to be simple 25bp hike to 4.25%, in line with expectations, with a 7-2 split as Silvana Tenreyro and Swati Dhingra again voted to keep rates on hold. The recent inflation increase to 10.4%, alongside upward revisions to its near-term growth forecast and downward revisions to unemployment justified the hike. Markets see one more hike taking the peak to 4.5%, but the next 2 months of data before May’s meeting will be key - 4.25% could still well be the peak as our economists expect.

As for longer term rates, they have continued to fall in line with global bond yields following the Fed decision, as shown below. Again we now have a fairly significant discount between core swap rates and BoE base rate, which shows how the market is discounting a gradual fall in the benchmark rate; but as mentioned in a previous wrap it makes hedging look attractive relative to where we have been during this cycle of rate hikes - where swap rates were much higher than BoE base rate.

UK Budget

A quick note on the budget, which I feel given the events of the last, well, mini-budget in September, cannot be ignored. Luckily we have not had anywhere near the type of reaction that we saw then, which Jeremy Hunt would have been extremely conscious of. Markets were not expecting fireworks and ultimately that proved to be the case. Mr Hunt provided some nuggets of support for households and businesses over the next few years, but was constrained by lower GDP/higher inflation forecasts later down the line which hindered his ability to loosen the purse strings even further. Saving some firepower for next year’s pre-election budget was likely part of the plan too. The reaction in the gilt market was limited given the wider global picture taking precedence, but issuance for this fiscal year was in focus as this would have to be absorbed by investors with the Bank of England no longer in the market. 

The Debt Management Office detailed plans to issue £241bn of bonds in the coming fiscal year, higher than the £233bn estimated. Breaking this down further, there will be a greater weight towards shorter maturities with 36% of overall issuance being in the bucket of 7 years or less, up from an average around 27%. From a fundamental point of view naturally this should put a floor under gilt yields with greater supply and less demand, but as mentioned above this is currently being masked.

All data in this article, unless otherwise stated, is sourced from Bloomberg.

Cameron Willard, Capital Markets

All data in this article, unless otherwise stated, is sourced from Bloomberg